What Is a 401(k)?

One of the first things you are likely to encounter when you reach adulthood and begin investing is a 401(k) plan offered by your employer. Where pension plans once reigned supreme, offering a lifetime guarantee of checks in the mail during retirement regardless of stock market fluctuations, today the 401(k) plan has taken its place, giving individuals the opportunity to make far more money or lose everything in the process. Still, you may be wondering, 'What is a 401(k)?" and, just as important, "How does a 401(k) work?".

Never fear. This overview will explain the basics to you and help you make sense of the choices you have when it comes to funding your golden years.

What Is a 401(k)?

The term 401(k) refers to a section of the tax code permitting individuals to establish special types of tax-advantaged retirement accounts. There are two types of 401(k) accounts.

What is a Traditional 401(k)?A traditional 401(k) allows an employee to save money toward his or her retirement and receive a tax deduction. The employer sponsoring the plan can offer to match any money the employee puts into his or her account, also receiving a tax deduction. The money in the 401(k) account, which belongs to the employee, can grow tax-deferred until retirement. That means you don't have to pay taxes on the ​dividends, interest, and rents you generate from the investments made within the account. After the 401(k) owner reaches the age of 59 1/2, he or she can begin taking regular withdrawals from the account, at which point regular taxes must be paid on the money just as if it had been earned from a paycheck.

What is a Roth 401(k)? A Roth 401(k) works much the same way with a few notable exceptions, the major being that there is no tax deduction given to the employee at the time he or she contributes money to the account. Instead, the money grows tax-free and, upon retirement, not a single penny in taxes should be owed when withdrawals are made.

Why Are 401(k) Retirement Accounts Considered So Attractive?

If you are good with money and responsible, a 401(k) retirement system can be much more advantageous than a regular pension plan because you can find intelligent things to do with your capital. For those who struggle with sticking with a plan, are tempted to frequently trade and drive up frictional expenses, or who don't understand how mutual funds or the stock market works, the 401(k) system can be an unmitigated disaster.

The real appeal of the 401(k) comes down to tax benefits. With a traditional 401(k), a moderately successful middle manager saving $5,000 at a company with good benefits would not only see a tax break of around $1,000, but also receive matching funds of $5,000, turning the original $5,000 contribution into $11,000 instantly before a single investment has been made. Then, on top of that, the dividends, interest income, and rents get to compound tax-deferred until retirement, which is often decades in the future.

It is a great combination that can be harnessed into a serious wealth building strategy for those who are disciplined enough to never raid their nest egg.

What Are the Downsides of the 401(k) Retirement Account System?

The downside of the 401(k) system is that it allows people to access their money in emergencies. That may seem like a good thing, but one of the reasons the pension system worked better for more people as they couldn't touch the money that had been put aside for their benefit. They couldn't make a stupid investment and lose it. They couldn't go to Las Vegas and gamble it away at the craps table. As long as they retired after a career of service, the checks showed up in the mail.

We can't tell you how many times people have written me saying they had to drain their 401(k) account, paying regular income taxes plus the 10% early withdrawal penalty, because they were going to lose their house or have their car repossessed. In the past, with the pension system, they would have been forced to come up with another solution; not jeopardize their retirement.

In short, the 401(k) system is exasperating the gap between the rich and the poor. Those who are able to manage their affairs have more opportunities to do intelligent things and make money. Those who have poor long-term decision making or are unable to act rationally when facing the vicissitudes and volatility of the stock market find themselves unable to heat their homes during the years when they should be sailing around the world.

Another drawback of the 401(k) is that 401(k) contribution limits restrict the total amount of money you can shelter each year. If you are high income and married, you can often get around this by maintaining dual 401(k) accounts for both spouses, as well as dual Traditional IRAs. Then, you can get into more complex arrangements such as equity-indexed variable annuity insurance contracts. Intelligently structured, you can save hundreds of thousands of dollars each year in tax-sheltered retirement accounts.